Leveraged Buyouts (LBOs) is a term for buying a company using mostly borrowed money. The goal of the LBO is to enable the firm to cut costs and use those savings to pay off some of their debt or invest in growth opportunities.
Gearing or financial leverage represents the ratio between the funds provided by lenders and owners to finance a firm, compared with the funds provided by its stockholders. An increase in gearing can be achieved by issuing more debt or selling shares, while a decrease can be achieved by buying back debt or offering dividends. For example, a firm with 50% of gearing would have twice as much money coming in from lenders than it has coming in from its stockholders.
A highly geared company is considered as such because it’s very risky and therefore the interest rate on the borrowed funds is high (in relation to its equity). Oftentimes, such companies will pay a dividend (money to the stockholders) before they make any major capital investments. That’s because it is risky and if things go wrong, money is needed for another dividend, and if things go well then it can be reinvested into the company and provide more value than just a one-time high yield.
Leveraged Buyouts (LBOs) as a part of Private Equity (PE)
Leveraged Buyout (LBO) and Private Equity (PE) are often used interchangeably, but they are not. A Leveraged buyout is when a private equity company buys another company using mostly borrowed money. This enables the investors in the PE firm to get an attractive rate of return (previously 15-20%, now it’s more like 8-12%). A Private Equity firm invests its clients’ money into different businesses, with the expectation that they will grow and provide a return to the fund.
An example of an LBO is when Kohlberg Kravis Roberts & Co. (KKR) purchased RJR Nabisco for $31 billion in 1988. KKR used $5 billion of equity and borrowed the rest, thus putting the total debt at roughly 4.5 times RJR Nabisco’s pre-tax income.
Ways for a company to improve its LBOs using private equity:
Leverage buyouts involve an element of financial leverage
In that the company’s assets are used as collateral for borrowing the money. If the return on new investments is expected to be higher than interest payments, it can make sense to take on additional debt and invest in the new opportunity.
A private equity firm that provides financing
A private equity firm that provides financing and advice can add value by helping a company identify and prioritize investment opportunities that can boost its bottom line. This is because the private equity firm, which typically has a small team of experienced professionals who have worked across multiple companies, can spot opportunities that are not obvious to management.
A company will often use money from an LBO
A company will often use money from an LBO to buy back shares in itself. When this happens, earnings per share (EPS) increases because there are fewer shares outstanding. If an LBO takes place at a time when there is substantial distress in the financial markets, such as the credit crunch of 2009, those companies that can actually buy back their shares with cash will see their share prices shoot up.
Not all LBOs work out to the benefit of the company
It’s important to note that not all LBOs work out to the benefit of the company’s stockholders or creditors. If for some reason, the new owners can’t improve performance, then they won’t be able to repay their debt and the company will go bankrupt. This is very similar to an Equity buyout (MBO).
Here are some tips on how you could improve your leveraged buyouts:
The financing structure of an LBO is prominent to its success. When the debt ratio is high, there are usually excessive financial charges (interest rates), which can be burdensome for an operating company. Therefore, companies that have extraordinary cash flows or some other economic cushion might not benefit very much from an LBO structure because it’s financially inefficient. However, if the company already has high debt ratios, then it could be beneficial for it to refinance through an LBO with a private equity firm in order to improve or maintain its credit rating.
- When there is more than one business in a sector that is capable of performing well, private equity firms tend to have more options to choose from.
- Using actual numbers can make your article more interesting, it’s good practice to use comparative data in order to support the argument you are trying to make.
- When there is high leverage (in terms of debt), flexibility (i.e., strong financials) is key, companies that have a lot of free cash flow might be able to improve their leverage buyout by taking on more debt and buying an underperforming company.
- When a business is going through a leveraged buyout, it usually refinances the entity’s existing debt with new borrowings from lenders who will charge a higher interest rate than was paid previously on the debt.
- Private equity firms can improve LBOs by leveraging their skill sets in order to take advantage of an emerging opportunity. For example, the private equity firm could determine that a business’s position in its sector is strong enough but future opportunities are limited because it does not have sufficient resources or expertise necessary to make the most out of them.
- It’s best to have a concrete thesis and then logically argue why your argument is sound, instead of writing an article that is full of vague claims you can’t back up with real evidence.
- To improve the success rates of LBOs, private equity firms will typically look for opportunities where there is a substantial amount of private, rather than public, ownership. This is because opportunities to improve the operations of a company become more limited when its shares are held by too many shareholders who do not have the power to approve or deny transactions that could maximize value for them.
- A leveraged buyout occurs when an investment firm acquires a controlling interest in an existing business, usually with the goal of liquidating it.
- A management buyout (MBO) is when a group of managers within a company purchase 100% ownership interest in an operating entity from either another corporation or all its existing shareholders. This allows them to operate without interference from outside owners and is considered more ethical than a LBO because it does not involve the debt financing that LBOs do.
- An Asset buyout (ABO) occurs when a company acquires its assets and is usually used in order to expand the activities of an operating business by acquiring them from another company.
An examples of a well known LBOs
Cerberus Capital – 2011
For example, Cerberus Capital Management LP is a private equity firm that specializes in leveraging asset-oriented businesses. They completed an ABO in 2011 when they acquired Chrysler Financial Services from the U.S. Treasury, making it a business unit within their holding company called “Cerberus Capital Management”.
Since 2009, Cerberus has been investing in troubled companies that are “financial services” companies that offer banking, lending, leasing and/or asset management.
Credit Acceptance Corporation is an example of a company Cerberus Capital Management LP owns, because it provides financing to subprime consumers who are unable to acquire traditional forms of credit.
Cerberus purchased Chrysler Financial Services from the government in 2010 because they saw value in buying distressed financial services businesses that they could turn around and sell at a higher price.
Cerberus Capital Management LP is known for their expertise in turnaround situations, so it makes sense why they would acquire Chrysler Financial Services because the business was only profitable after Cerberus re-structured its operations.
They used $8 billion of their own capital and $1.8 billion from institutional investors to complete the transaction.
RJR Nabisco – 1980
In May 1980, the RJR Nabisco leveraged buyout was considered one of largest LBOs in history when a private equity firm called Kohlberg Kravis Roberts & Co. acquired all outstanding shares for $25 per share or a total value of $31 million.
The RJR Nabisco buyout included Legg Mason, Kohlberg Kravis Roberts & Co., Merrill Lynch, Shearson Lehman Brothers, T. Rowe Price Associates, S.C. Johnson & Son Inc., The Allstate Corporation and about 2,000 smaller shareholders affiliated with Two Harbors Investment Corp., which owned 13 percent of RJR Nabisco.
Mulheren was the lead partner in the deal and used a $4 billion investment from institutional investors to succeed with his idea to buy out the company. He envisioned an initial public offering (IPO) within 18 months, but it did not happen until six years later when stock prices were much lower.
The management of RJR Nabisco saw the value in LBOs by choosing to sell their company, because they would have had more opportunities for improvement if they owned 100% of its shares.